On December 13, 2018, proposed regulations (Proposed Regulations) were issued that reduce certain compliance obligations under Sections 1471-1474 (the Foreign Account Tax Compliance Act (FATCA)) of the Internal Revenue Code of 1986, as amended (Code) and Sections 1441-1446 of the Code. FATCA generally requires withholding 30% on certain US source payments made to foreign financial institutions (FFIs) unless the FFI has entered into an FFI agreement with the Internal Revenue Service (IRS) or the FFI is resident in a country that has an Intergovernmental Agreement (IGA) in force. Sections 1441-1446 of the Code impose 30% withholding on a US source payment made to a foreign person unless a statutory or treaty exception applies.
Elimination of Withholding on Payments of Gross Proceeds. The Proposed Regulations eliminate the requirement of withholding on “gross proceeds” by removing the term from the definition of “withholdable payment” under FATCA. Gross proceeds are total amounts realized from a sale or disposition of property producing interest or dividends from sources in the US. Due to the responses from commenters regarding the burden of this requirement, the IRS and the Department of the Treasury (Treasury) had continued to push back the implementation date for the withholding requirement for gross proceeds, which had most recently been set to begin January 1, 2019. The IRS and Treasury concluded that such withholding on gross proceeds is no longer necessary given the international cooperation regarding FATCA reporting, noting the predominance of IGAs. Although the statute specifically includes gross proceeds within the definition of “withholdable payment,” it also gives the Treasury discretion to exclude any amounts from such definition.
Eversheds Sutherland Observation. While we do not anticipate that the IRS and Treasury would later decide to completely reverse course and require withholding on gross proceeds, any such decision would be subject to additional judicial scrutiny. An agency deciding to reverse a prior rule must provide a more detailed justification for reversal than it would for the initial rule, especially where the new rule rests on factual determinations that contradict those made in support of the initial rule. See FCC v. Fox Television Stations, 556 U.S. 502 (2009).
Deferral of Withholding on Foreign Passthru Payments. Under FATCA, an FFI that has entered into an IGA with the IRS must withhold on any passthru payments made to recalcitrant account holders or FFIs that do not comply with FATCA obligations. Withholding on foreign passthru payments was scheduled to begin on January 1, 2019. The Proposed Regulations further defer the implementation date of withholding on foreign passthru payments until two years after the published date of the final regulations defining the term “foreign passthru payment.” The IRS and Treasury, while again noting the success of IGAs in implementing FATCA, stated that they still intend to consider developing a system to withhold on foreign passthru payments due to potential abuse by recalcitrant account holders and non-participating FFIs.
Elimination of Withholding on Non-Cash Value Insurance Premiums. The Proposed Regulations provide that premiums for insurance contracts that lack cash value are excluded non-financial payments that are not subject to withholding. The preamble to the Proposed Regulations indicates that requiring reporting under FATCA strengthened the IRS’s enforcement efforts, with respect to the use of the insurance exception to passive foreign investment company (PFIC) status, and that, as a result of recent law changes, this is no longer necessary. The prior law insurance exception provided that foreign corporations predominantly engaged in the active conduct of an insurance business that would be characterized as insurance companies for US federal tax purposes would not be characterized as PFICs, and thus their shareholders would not be subject to PFIC reporting and anti-deferral rules. The Tax Cuts and Jobs Act, instituted a more limited insurance exception under the PFIC rules by requiring foreign insurance companies to additionally have a specified percentage of insurance liabilities to total assets in order to meet the exception. The preamble further indicates that, as a result of this change, it is anticipated that insurance companies which do not meet the revised insurance exception will amend their business models or their shareholders will be required to comply with the PFIC reporting requirements, accordingly, eliminating the need to withhold premiums for non-cash value policies.
Clarification of Definition of Investment Entity. Under current Reg. § 1.1471-5(e)(4)(i)(B), an entity is an investment entity (and therefore a financial institution) if the entity’s gross income is primarily attributable to investing, reinvesting or trading in financial assets, and the entity is “managed by” another entity that is a depository institution, custodial institution, insurance company or an investment entity described in Reg. § 1.1471-5(e)(4)(i)(A). The Proposed Regulations clarify the term “investment entity” by providing that an entity is not “managed by” another entity just because the first entity makes investments in the latter entity that is a mutual fund, an exchange-traded fund or a collective investment entity that is widely held and is subject to investor-protection regulations. This change correlates to similar guidance published by the Organisation for Economic Co-operation and Development’s (OECD) interpretation of “managed by.” The preamble to the Proposed Regulations indicates that “managed by” refers to professional management with discretionary authority.
Guidance on Due Diligence Requirements for Withholding Agents. Pursuant to Sections 1441-1446 of the Code, a withholding agent must generally obtain either a withholding certificate that makes a treaty claim or documentary evidence to apply a reduced rate of, or an exemption to, withholding based on a claim for benefits under an applicable tax treaty. The treaty claim must specify the limitation on benefits (LOB) provision relied upon in the applicable treaty when an entity’s beneficial owner provides a treaty claim to claim treaty benefits. This requirement for withholding agents to obtain updated treaty statements that comply by specifying the LOB provision for certain preexisting accounts was slated to begin January 1, 2019. There is also a three-year validity period for treaty statements under the existing regulations.
The Proposed Regulations extend the deadline for withholding agents to obtain treaty statements specifying the LOB provisions identified for preexisting accounts until January 1, 2020, and add exceptions to the three-year validity period for treaty statements for entities whose qualifications under an applicable treaty are unlikely to change, such as tax-exempt organizations and publicly held corporations. The Proposed Regulations also allow a withholding agent to rely on a taxpayer’s claim on a treaty statement, regarding the taxpayer’s reliance on a specific LOB provision, without actual knowledge that such claim is unreliable, and treats documentary evidence submitted to establish an individual’s permanent residence address, despite being subject to a hold mail instruction, as supporting the individual’s claim of foreign status or residence for claiming treaty benefits.
Modifications Related to Credits and Refunds of Overwithheld Taxes. If a withholding agent has overwithheld and deposited the tax but is unable or unwilling to adjust the withholding, currently a beneficial owner or payee must file a claim for credit or refund with the IRS in order to obtain the overwithheld tax. The Proposed Regulations require a withholding agent that withholds in a subsequent year to designate the deposit as attributable to the preceding year and amends the reimbursement procedure to permit the agent to use the extended filing date to make a repayment and claim a credit. This change modifies the lag reporting method and avoids a mismatch between the years in which income is reported and the withholding is credited.
Applicability. Taxpayers may generally rely prospectively on the Proposed Regulations until final regulations are issued. However, as depicted in the table below, the provisions applying to the elimination of withholding tax on non-cash value insurance premiums, clarification of the definition of “managed by,” and the allowance for a permanent residence address subject to a hold mail instruction, may be relied upon for all open tax years until the issuance of final regulations. Additionally, taxpayers may not rely upon the changes relating to credits and refunds of withheld tax until the 2019 Instructions to IRS Forms 1042 and 1042-S are amended.